It may be controversial, but more clients are doing it with advisors' help.
Todd Terhorst, president of Diversified Wealth Management in Minneapolis, recently met with a couple in their mid-thirties who had their sights set on buying a rental property at a condominium complex in Florida, but limited access to traditional real estate financing sources. Because the couple had recently purchased a residence and had a hefty mortgage, getting another mortgage loan would be difficult, if not impossible. They couldn't borrow against their home's equity, since they had very little at that point. The couple's free cash flow was more of a trickle, and they didn't have much money in their savings accounts.
What they did have were two sizable rollover IRAs, and a strong desire to purchase the condominium. They also had on their side an IRS code that specifically bars a surprisingly small menu of investments, and a financial advisor who was willing to guide them through the transaction.
"When we laid out the options, I mentioned that it is possible to use money in an IRA to fund real estate investments," he says. "After I explained all the pros and cons, they felt it was the way to go."
Real estate is certainly not Terhort's first choice for IRA and qualified plan investing, and traditional stocks, bonds and mutual funds dominate the vast majority of his clients' portfolios. To diversify a retirement plan, he usually turns to real estate investment trusts or mutual funds that invest in them. Clients with the urge to touch and feel what they own are counseled to use money outside of their retirement accounts, if possible. After exploring all the pros and cons, "only about 2%" of his clients decide to use their IRAs to buy investment properties.
But in certain instances, such as the couple short on cash but long on their desire to fulfill their Florida dream, using IRA money may be the only alternative available. While having clients invest part of a retirement plan in real estate requires extra effort, Terhorst thinks it pays off in the long run. "I'm providing service and advice that is hard to find anywhere else, and if there are other assets to manage there's a good chance they'll use me," he says. "Besides, if they find another advisor who's willing to guide them through the transaction I'll lose the business forever."
Despite the added complexity involved, an increasing number of financial advisors are at least warming up to the notion of putting a portion of some of their clients' IRA assets in alternative investments such as real estate. Some do it to diversify portfolios beyond the traditional financial markets, which they fear will deliver modest returns in the years to come. Others, like Terhorst, see offering alternative investments as a way to distinguish themselves from the legions of financial advisors who are likely to stonewall the idea.
"People are getting tired of low stock market returns with no recourse, yet studies show that less than 2% of the population knows they can invest in real estate with an IRA," says Tom W. Anderson, President of PENSCO, a firm that administers the self-directed IRAs and other retirement plans for about 3,500 financial advisors around the country. "A lot of financial advisors don't know it either."
By law, IRAs are not allowed to invest in certain assets, including life insurance and collectibles such as art, rugs, antiques, gems and stamps. Coins are also prohibited, except for certain types of gold or silver U.S. government coins. But a surprisingly large roster of other investments are fair game, and stories of people using IRA money to purchase everything from thoroughbred horses to Dallas Cowboys season tickets have long circulated in financial service industry circles.
It may just be the latest hot trend, but Anderson says real estate is the alternative investment of choice for self-directed retirement plans. "Before the market downturn a few years ago, a lot of money in self-directed IRAs went into private equity and we got a lot of business from the dotcoms, " he observes. "Now, the main reason financial advisors set up self-directed IRAs is real estate."
The investment may take a number of forms, including land, commercial property or a rental condominium. It may also involve a more passive form of real estate investing, such as a promissory note tied to a mortgage. Anderson says that the typical candidate for a self-directed IRA that contains real estate is someone age 40 to 65 who has accumulated substantial wealth in a retirement plan and is looking to diversify beyond traditional investments.